SYNOPSIS: The Japanese policy of heavy fiscal spending to generate a Self-Sustaining Economic boom is silly and will lead to larger problems in the long run.

Japan is currently engaged in the largest peacetime fiscal stimulus
in history, with a budget deficit of around 10 percent of GDP. And this
stimulus is working in the narrow sense that it has headed off the imminent
risk of a deflationary spiral, and generated some economic growth. On the
other hand, deficits this size cannot be continued over the long haul;
Japan now has Italian (or Belgian) levels of internal debt, together with
large implicit liabilities associated with its awkward demographics. So
the current strategy can work in the larger sense only if it succeeds in
jump-starting the economy, in eventually generating a self-sustaining recovery
that persists even after the stimulus is phased out.

Is this likely? The phrase "self-sustaining recovery" trips lightly
off the tongue of economic officials; but it is in fact a remarkably exotic
idea. The purpose of this note is to expose this hidden exoticism - to
show that anyone who believes that temporary fiscal stimulus will produce
sustained recovery is implicitly endorsing a rather fancy economic model,
the sort of model that finance ministries would under normal circumstances
regard as implausible and disreputable.

As a starting point for this discussion, we should notice that Japan
has unwittingly managed to turn itself into an old-fashioned Keynesian
economy, the sort of economy envisioned in the original, 1948 edition of
Samuelson's textbook. With large excess capacity, Japan is unmistakably
constrained by demand rather than supply; with call money rates hard up
against zero, Japan has the fixed interest rate assumed in naive multiplier
analysis. So leaving aside foreign trade and the exchange rate (which really
do not change the fundamental picture - see my discussion in Japan: still
trapped), Japan's economy can be pictured using the good old "Keynesian
cross" (also known as a Samuelson cross) depicted in Figure
1 .

The figure graphs the economy's total income - GDP - against its total
spending. The equilibrium level of output is determined by two conditions.
First, income must equal spending: hence the 45-degree line where income
equals spending. Second, spending itself depends positively on income,
as represented by the upward-sloping line EE. In Figure 1 I have
followed the textbook convention of assuming that a dollar of additional
income raises spending by less than a dollar (sorry, 104 yen raise spending
by less than ...), so that EE is flatter than the 45-degree line,
and there is a unique equilibrium level of output.

In this conventional picture, deficit spending can raise EE,
say to E'E', and thereby expand the economy. But if the deficits
are unsustainable, this is only a temporary solution. Eventually the stimulus
must be scaled back, and EE will shift back down; the economy will
be back in slump. (You might think of this as a potted history of the Hashimoto
fiasco).

When, then, can fiscal stimulus work as a long-run solution? There seem
to be two possible answers. The first is that deficit spending can serve
as a bridge over troubled waters. Suppose that the factors depressing private
spending are clearly temporary - for example, there is a clearly temporary
financial crisis underway, or investment is on hold pending some sort of
financial cleanup, etc.. That is, there are good reasons to think that
EE
will shift up in the not-too-distant future in any case; so propping it
up artificially with fiscal stimulus is simply a holding action until the
cavalry arrives.

It's actually hard to come up with good examples of this kind of fiscal
program - maybe Sweden's efforts to ride out the first oil shock in the
mid-70s. In the case of Japan, a starry-eyed optimist might argue that
restructuring of Japanese banks and corporations will eventually create
a "new economy" that generates a lot of investment. A more likely scenario,
however, is that the prolonged process of restructuring will keep consumers
nervous and if anything depress demand. That cavalry may be a long time
in coming.

Anyway, Japanese officials seem to have something more in mind than
waiting for good news to arrive. Their idea is that the massive stimulus
now underway will not need to be continued, because it will generate that
"self-sustaining recovery". What would the Keynesian cross have to look
like for that view to be justified?

The answer is that it would have to look like Figure
2 . Over some range increases in income would have to raise spending
more than one-for-one, so that there would be multiple equilibrium levels
of income. Of the three equilibria illustrated in Figure 2, the middle
one will be unstable under any plausible adjustment story, so there will
be two interesting possibilities: a high-level equilibrium (perhaps at
above-full-employment output, so that it would allow interest rates to
be raised off the floor and normal monetary policy to resume), and a low-level
trap. A sufficiently large fiscal stimulus, then, would push EE
up to E'E', and hence jolt the economy out of the low level trap.
If sustained long enough, it would generate favorable expectations by the
private sector, so that when the stimulus is removed and EE drops
back to its original position the economy will end up in the high-level
equilibrium, not fall back into depression.

Do you believe this picture? There is nothing wrong with multiple equilibrium
stories in macroeconomics; indeed, sometimes they seem to be the only way
to make sense of events. Just a few days ago I cheerfully used a diagram
not too different from this one to make sense of the Asian financial crisis
( Analytical afterthoughts
on the Asian crisis ). But anyone who has played this sort of analytical
game knows that multiple equilibria are something to be invoked only sparingly:
as William of Ockham might have said, thou shalt not multiply equilibria
unnecessarily. The point is that multiple equilibria are too easy - they
are a device that can justify practically any policy, and should therefore
not be proposed unless you have some compelling reason to think they must
be there.

Now you could argue that the experience of the Depression and after
provides just such evidence. Many economists thought that with the end
of World War II spending the United States would revert to Depression-type
conditions; a whole school of thought, the "secular stagnation" hypothesis,
was built around that idea. In fact, once jolted out of depression, the
U.S. did not fall back; one explanation is a story something like that
in Figure 2.

But it is quite a stretch to argue that Japan in the 90s is a parallel
case. It might be; but an at least equally, if not more, plausible story
is that Japan has a structural excess of saving over investment, even at
a zero interest rate; in that case a temporary fiscal stimulus will produce
only temporary results.

What continues to amaze me is this: Japan's current strategy of massive,
unsustainable deficit spending in the hopes that this will somehow generate
a self-sustained recovery is currently regarded as the orthodox, sensible
thing to do - even though it can be justified only by exotic stories about
multiple equilibria, the sort of thing you would imagine only a professor
could believe. Meanwhile further steps on monetary policy - the sort of
thing you would advocate if you believed in a more conventional, boring
model, one in which the problem is simply a question of the savings-investment
balance - are rejected as dangerously radical and unbecoming of a dignified
economy.